Bank Deals Are Getting Hefty IRS Breaks

Some in Congress are critical and note the possibility of abuse, including from one recent change in the tax code's Section 382.
Stephen TaubOctober 31, 2008

A little-noticed tax break that the Internal Revenue Service recently began providing to acquisitive banks may be stimulating their interest in merging — and, critics say, could be unfairly burdening taxpayers.

At issue is Section 382 of the tax code, which was enacted by Congress to prevent tax-motivated acquisitions of loss corporations. On September 30, though, the IRS issued a notice altering Section 382 as it affects banks, effectively removing the limit to how much taxable income a purchasing bank, thrift, industrial loan company, or trust company could deduct after an acquisition.

Previously, most criticism of the banking bailouts has involved concerns that federal funds are going to help pay for mergers. But this new tax wrinkle has broadened those concerns. Among the critics of the code change is Sen. Charles E. Schumer (D-N.Y.), who is upset because Congress was not asked to approve the change.

Since the tax change was made, three banks stand to reap billions of dollars in savings through takeovers of smaller banks, notes Schumer. Wells Fargo, which beat out Citigroup in a battle to acquire Wachovia earlier this month, stands to save $19.4 billion as a result of the change, and it is estimated that PNC Financial will save more than $5.1 billion in its takeover of National City, according to Schumer. (Wells Fargo and PNC Financial have already benefited from $25 billion and $7.7 billion, respectively, in capital injections from the government.) Banco Santander SA, which is acquiring the remaining assets of Sovereign Bancorp, is also reported to benefit from billions of dollars in tax write-offs from its merger, the senator says.

“I am concerned that the notice, which was never debated by Congress, could end up costing taxpayers tens of billions of more dollars, on top of the hundreds of billions of dollars already approved by Congress in the financial rescue plan,” Schumer wrote in a letter sent to Treasury Secretary Henry Paulson and IRS commissioner Doug Shulman.

Schumer questioned the need for the tax change after the implementation of the Treasury’s capital injection program and expressed concern that the change will result in tens of billions of lost tax dollars for the federal government, which has already committed $700 billion in resources to many of these same financial institutions under the rescue plan approved by Congress last month. Schumer also questioned whether the tax change creates an unnecessary incentive for acquisition-minded banks to pursue takeovers that provide no benefit to the stability of the larger financial system, but simply represent an opportunity for firms seeking future tax deductions to shelter their earnings.

“I also fear that the notice could have the unintended consequence of motivating more financial firms wanting future tax deductions to shelter their earnings to buy competitors, leading to more consolidation in the financial industry than would be necessary to restore stability in the financial sector,” added Schumer.

Criticism of how banks are using the bailout money has been bipartisan. Congressman John Boehner (R-Ohio) sent his own letter to Paulson this week, raising concerns about how some funds made available under the recently enacted economic rescue package are being used by some financial institutions. Citing news reports, Boehner highlighted one bank that is using funds from the Troubled Assets Relief Program to purchase another bank, and other reports indicating that some institutions have considered using TARP funds for employee pay raises and executive bonuses. Further, Boehner pointed out that these types of expenditures were never described by the Treasury Secretary or expected by Congress when the relief plan was sent to the President on October 3.

“Funds made available under the economic rescue package should not be used to pay for bank acquisitions, raises, and executive bonuses,” asserted Boehner. “These are not the types of expenditures you described during your many discussions on Capitol Hill earlier this fall, and these certainly are not the types of expenditures Members of Congress envisioned when the plan was sent to the President earlier this month.”

The Section 382 rewrite is not the first tax-code change made in the wake of the credit crisis. The Emergency Economic Stabilization Act of 2008 also permits qualified banks to sidestep tax-code provisions in exchange for pumping capital into the failing mortgage lenders Fannie Mae and Freddie Mac, says a new report by tax expert Robert Willens.

Specifically, qualified banks that buy preferred shares in Fannie or Freddie are permitted to book any gain or loss from the sale or exchange of the shares as ordinary loss or ordinary income, rather than capital gains or losses. That means that even if the new shareholders are left with poorly performing Fannie and Freddie shares, they are still not stuck with capital losses, which are “exceedingly difficult” to offset.

Willens explains that capital losses may only be offset against capital gain income. But ordinary losses — also known as net operating losses — may be offset by any income generated by the company’s business. In fact, the IRS allows companies that have posted an NOL to save up to two years’ worth of the losses and use them to offset income generated over the next 20 years. By applying the NOLs to future periods, a company’s taxable income is decreased, and the corporation pays less to Uncle Sam. In contrast, net capital losses may only be carried back to the three taxable years preceding the year in which the loss was sustained.